This e-book is for anyone who cares about their business and, like any service provider, wants to ensure they are equipped with the right information to hire the right people. It will also give you insight into why valuation is so important and how you can begin to use this new knowledge to your advantage.
InteleK’s accredited valuation professionals have delivered valuation engagements for everything from mom-and-pop shops to Fortune 500 companies and from strategic planning purposes to complex litigation matters involving local and state tax authorities as well as in partnership and marital disputes.
As the old adage goes, “knowledge is power”, and we aim to see as many people as possible gaining the knowledge to obtain the most successful valuation engagement.
A Guide to a Successful Business Valuation Engagement — Part 1
Part 1 of this e-book is an introduction to the process of conducting a business valuation engagement, and provides answers to questions such as why you would need a valuation, what to look for in a business appraiser, as well as many other factors you should consider.
Step #1: Why Should I Get a Business Valuation?
Business valuations are almost always never thought of until it’s too late.
Regardless of the stage or phase of your business, there could be a range of reasons why a business valuation needs to be conducted. However, all too often, we see business owners not being proactive in these situations, but rather reactive, and by then it is usually too late to use a valuation to maximize the favorable impact of the outcome for their specific situation (this is especially not ideal when there is a lot of money on the table). As an example, we have seen a circumstance in which estate planning was left unattended until the time of death, costing the heir millions in additional taxes.
A business’ value is the ultimate performance metric or reasons for doing something to grow and improve (or perhaps offload) the business, but most business owners don’t think this way. Take this hypothetical but all-too-typical exchange as an example:
“Sally, why are you trying to improve your social media marketing?”
“To create better awareness of my business, which will attract more customers.”
“Ok great. And what will more customers do?”
“They will buy my services and increase sales.”
“Super. And what will that do?”
“Well, it should enable me to make more profit, which means more money for me.”
“Exactly. And what does more profit and money mean?”
“Um, well…it means that my business will become more valuable.”
“Exactly. As they say, ‘All roads lead to Rome’!”
In a business context, just about all questions and answers lead to the overall value of the business. Where, how, and why business owners do things can influence their business’ value negatively or positively, and owners often do things counterintuitively to what they really want. Therefore, understanding what your valuation goals are is very important, and it’s a great exercise for owners to think backwards when problem solving or taking action within their business. In other words, “If I am trying to achieve X with my business’ value, what do I need to do?”
Being proactive is the key, having the knowledge to achieve your valuation goals, and importantly, lower your risk to adverse situations (like a tax audit), makes getting a valuation worth every penny.
Step #2: Valuing a Business (The Moving Target Analogy)
The value of a business is best thought of as a moving target. Like any asset, its value is specific to a point in time: its value today could be very different than three months ago, next month, or next year. However, unlike other assets, there are many moving pieces which make the art of determining its value even more difficult.
A car or a house is a much simpler asset than a business—it has fewer moving pieces and almost all its parts are tangible. Also, there is what’s referred to as a “ready market” for them, meaning that lots of people are selling and buying similar assets that can be compared rather easily. Businesses are not as simple as this; there are far fewer buyers and sellers, and no two businesses are exactly the same.
As an example of the importance of time and of how quickly things can change, you could sign a contract with a new supplier that halves your costs. Or sign a contract with a new client that will increase your sales by 15%. Or, frighteningly, work that was done six months ago can come back to haunt you with legal action because a troubled employee did not do the job properly. In each of these examples, the company’s value can literally change overnight.
What date specifically does your business need to be valued? And what impact will that have on its value?
Step #3: Reasons for a Business Valuation
At various stages of a business’ life cycle, valuations are required. Here are some of the most common reasons for this:
- Gifting shares of the company
- Estate planning
- Selling to a third party
- Internal planning (to make strategic decisions)
- Financial reporting (purchase price allocation, financial instruments, etc.)
- Disputes between business partners
- Marital dissolution
- Employee share plans
Now, let’s return to being reactive rather than proactive. Your intentions and best interests are not always the same—they change with the time and with every valuation purpose. In some situations, you could benefit from a high valuation (in a potential sale, for example) but in some other situations a high valuation could play against you (when measuring your exposure to a liability, perhaps). In each case, we always want the most accurate valuation using state-of-the-art tools to maximize your benefit while minimizing your risk. Lack of preparation for adverse events leaves you with fewer options to receive the maximum benefit.
The most common scenario is to consider exiting the business and selling to a third party. By the time the owners have had this thought, they are often too tired and have already “emotionally” left the business (whether partially or fully). The time to proactively change things has come and gone, and there’s no longer any energy or sufficient time to materially make improvements to their business and increase its value. They want to sell it as fast as selling a car or house (which isn’t how it works), and they often sell for less just to get the transaction done.
Step #4: How Do You Value a Business?
There are three main Valuation Approaches used within the business valuation framework:
The Income Approach — identifying how much earnings (profits) the company will generate into the future and valuing those future profits as of today (the present value). This is the most used and preferred method by valuation practitioners because it directly focuses on financial benefits owners can enjoy from those profits.
The Asset Approach — in simple terms, taking the total assets of the company converted to their economic value (which is not always the same as the historical value reported in the balance sheet) minus the total liabilities of the company converted to their current value as of the valuation date (again, this is not always the same as reported in the financial statements).
The Market Approach — comparing other companies that are similar enough to the one being valued. As mentioned previously, this is commonly used with houses and vehicles and can also be applied to private businesses when there are reasonably close or similar businesses to compare with. While no two businesses are exactly the same, we can find businesses that have a similar economic nature, even if they are in different industries. Some limitations of this approach include:
- The information needed to make these comparisons might not exist or records might not be accurately kept.
- People buy businesses for different reasons which makes the price change materially. For example, I buy the restaurant next door to eliminate my competition and expand my own restaurant, or I am buying a restaurant because I am a chef and moved to a new city, and I don’t want to work for someone else anymore. You would expect the first person to pay a lot more than the second person in this scenario for the business, but when comparing, we only see the price it transacted for and not the backstory.
Step #5: Who Values a Business?
There are a few different options—some better than others—and like any product or service you buy, you need to evaluate how much you want to invest to then receive in value/return. Some products and services are easy, like buying a chocolate bar or getting a carwash; there are few complexities in working out the value of these items, but as mentioned earlier, businesses’ have a lot more moving parts which, depending on who and how it is valued, can be the difference between tens of thousands, hundreds of thousands, or even millions of dollars. This is because of all these moving pieces, both the tangible and the always-trickier intangibles. It’s important to keep in mind that valuing a company is a combination of art and science.
There are valuation software options (which are science-based) that try to more or less calculate the value, but these are severely restricted because of the limited inputs into the software, and putting together the moving intangible pieces is next to impossible. They can be suitable for less important valuation purposes with the simplest and smallest businesses, but not for more complex situations in which the valuation will be relied upon – this is why professional appraisers exist.
Given that business valuation is a combination of art and science, it is intended to produce what the tax departments and courts require, which is an “opinion of value”. Therefore, you are left to identify whose opinion is valuable and how much you need to pay for that opinion. Here are a couple of scenarios to ask yourself about:
- Do I just want to know an approximate value to boast to my buddies at golf on the weekend?
- Am I selling my business that I’ve spent 20 years building, where a thoroughly justified opinion could add tens or even hundreds of thousands of dollars extra to the sale as compared to a less expensive opinion?
- Am I submitting this valuation to the IRS, for which I need a strong justification, so I am not audited or taken to court, which would potentially save tens or hundreds of thousands or even millions of dollars? It would absolutely be worth spending more for a rock-solid “opinion of value” that will most likely save me ten times that amount later.
Step #6: What to Look For in a Business Appraiser
The first step is to read this e-book in full to improve your base valuation knowledge. Doing so will help you to identify what your valuation purpose is and the type of valuation service you require.
The more important your valuation purpose, the more you will want to pay for the best appraiser you can afford. Factors that drive importance include how much money is on the table and the potential risks you might face.
First, as a baseline, let’s get a few of the basics out of the way:
- Is the appraiser accredited? (see the Framework section in Part 2 that identifies the various accreditations and what they mean)
- Like in any profession, it takes time to see enough situations that you can learn from, which will then give you a better product/service for your clients.
- Specialties (which ties in with experience) for some valuation purposes, like intangibles or financial instruments. These are considered specialties, and experience does count.
As mentioned in this e-book, just because someone is accredited does not mean they are good or even better than their competition; there are plenty of bad doctors, accountants, and mechanics out there just as well as there are ones who are capable and trustworthy. Appraisers are no different.
Now that the baseline has been established, you can now dig deeper:
- Will the appraiser take the time to get to know your situation and your company prior to identifying a price or issuing an engagement letter? This allows the appraiser to better advise you on the service you need, which saves you time, money, and risk.
- Can the appraiser explain your risk levels so that you can understand them and provide a solution to minimize them? Lack of discussion and communication in general about the risks attached to the valuation purpose are a huge red flag.
- The appraiser should be able to clearly outline the process and what your involvement is expected to be.
- The appraiser should also be able to explain the best service/valuation report you require for your specific, unique situation. This should be accompanied by a price that is justified and makes sense for the risks and complexity of your situation.
If the appraisers are unable to do any of the above, they are simply not worth it—regardless of the price they charge.
Step #7: How Much Does a Valuation Cost?
Like all things, the cost depends on several factors. Hypothetically, let’s assume that all accredited valuation practitioners are equal in terms of quality of output (which we know not to be the case, but this is just an example).
These are a few of the main price drivers:
- The type of valuation, whether a restricted appraisal report (shorter with less detail/justification; 50-100 pages), a full appraisal report (which includes all the detail required for the IRS/litigation; 150-300 pages), or maybe just the barebones with a short memo attached. Think of these options like this: “Do I buy the hatchback or the SUV with the bells and whistles?” Depending on your valuation purpose and what scrutiny it needs to withstand, you will know the type of valuation you need.
- Your specific business and the situation. Do you have a small and simple business, or do you have a larger, complex business with many moving pieces? Both may need a full report, but the second could easily be double the price (or more) when compared to the report for the smaller, simpler business.
- Accurate, clean, and timely information provided to the appraiser. As an example, disorganized or erroneous financial statements that need to be organized can increase the price.
Next, let’s look at the differences for the appraiser and their firm:
- Generally speaking, and as with most things, you get what you pay for. Often, the lower-priced valuations are priced the way they are because the appraiser can’t accurately determine the services you need nor has the ability to deliver the quality required, which puts you at a much higher risk for costly corrections later. The points mentioned above on what to look for in an appraiser will help solve this issue.
- Regarding firm/branding, often with mid- to larger-sized firms (like the big accounting firms) there is a perception (or misperception) that high quality is provided and therefore a higher price is justified, which does have truth to it. However, many times, you are simply paying for the large overheads of a big firm and all the high salaries of the people you will never even speak with.
A memo-style valuation for a simple business for internal planning purposes can be as small as $3,500 from a small but quality firm, and a full appraisal report for a single entity $6,000 to $20,000. For larger complex businesses, this can and should be higher than this. But the same product from a big accounting firm could easily be $100,000 plus.
Ensuring you get what you need and don’t overpay comes down to how well the appraiser can identify the right service for your needs and justify the price to where you completely understand, without any doubts as to what you’re paying for.
You want to:
- Understand why and predict when you could or will need a valuation. This helps to set your valuation goals.
- Be proactive, not reactive, about your company’s value, and make decisions at each turn about how this will impact your valuation goals. Get help early regarding what and how things determine your business’ value.
- When it comes the time to find the right “opinion of value”, do some research and see what value it has to you, as well as what difference it might make.
As always, you are trying to get the most accurate valuation using the most current tools available at the right moment so that you have a sufficient buffer to manage the outcomes.
If you already have further questions and want to start your valuation journey, InteleK would love to hear your story. You can make a complimentary appointment here.
A Guide to a Successful Business Valuation Engagement — Part 2
Part 2 of this e-book dives deeper into the technical elements of business valuations and will give you a well-rounded understanding of what professional valuation practitioners do when valuing a private business. But there’s no need to be scared! This is a simplified presentation that the less-financially-sophisticated person will understand and find very useful
Step #8: What Makes My Business Valuable?
This is not an easy question to answer. There may be a key driver that other drivers contribute to or can’t function without, or perhaps a previous key driver will not be one in the future. We have broken down the most common important drivers for you in the article Business Value Drivers—including technology, workforce, client relationships, organized accounting, and more. Pinpointing what drives value in your business and monitoring it over time will allow you to not lose sight of what is important in your decision making.
As you can see, there are a myriad of factors that drive value to a business. However, some are more important for certain businesses and less so for others. Knowing these factors and trying to improve them is great, but how do you put these together to identify the value itself? How do you coordinate the thousands of data points and marry both quantitative and qualitative data to arrive at one single number or a range of potential values? Well, when trying to understand any concept or tackle any problem, it’s best to start with the framework, which is what valuation professionals do on each and every valuation.
Step #9: Framework
Let’s start with the “who”, which we’ve already examined in Part 1. Valuation practitioners—like most professionals—must have certain training, education, and experience to gain a formally recognized accreditation or designation. The USA has five main business valuation professional associations with their own accreditation or designations for their members:
- American Institute of Certified Public Accountants (AICPA): Accredited in Business Valuation (ABV)
- American Society of Appraisers (ASA)
- National Association of Certified Valuators and Analysts (NACVA): Certified Valuation Analyst (CVA)
- Institute of Business Appraisers (IBA): Certified Business Appraiser (CBA)
- CFA Institute: Chartered Financial Analyst (CFA)
An accreditation helps lower the risk (to a sufficient level) of finding a practitioner who does not know what they are doing. But as in any profession, having the accreditation does not necessarily mean that you’re good at what you do (see Part 1 which discusses this in more detail).
One of the main benefits of these designations is that each member must follow a proven framework on each and every valuation engagement, which helps to produce a quality product and service.
This framework outlines the steps and considerations that must be followed by the practitioner in order to render a final valuation number that is consistent with the specific set of details of the case. An example would be a company being valued under a “premise of value” of “liquidation” instead of a “going concern”, meaning that the company is being valued with the intention of closing or stopping operations (i.e., being “liquidated” rather than a business that is considered to continue operating for the foreseeable future, which is classified as “going concern”). You can see already how this would have a big impact on the derived value.
The valuation approaches and valuation methods of the framework must also be considered, which we’ll touch on more in this section as well as provide more detailed explanations in following sections.
In short, the final valuation number you see is only valid for these framework decisions, and you should ask your practitioner to explain these to you.
Now that you understand the valuation process (see Part 1) we can move onto the “how”. So, how do you value a business?
Step #10: What Are You Valuing?
Until you ask yourself this question and really consider it, you don’t realize that it’s a multi-layered issue. Valuing a business can be thought of as having different levels or components, and depending on the purpose of the valuation, it will determine which components you will need valued.
For example, as is often in the sale of smaller, privately held businesses, an asset valuation is required, see our Valuing Assets article here. The buyer simply wants to buy the income-generating assets, such as furniture, fixtures, and equipment, plus all intangible assets, including business goodwill, but leaving all the existing liabilities and debt on the balance sheet behind, such as director loans, bank loans, etc. The purchased “assets” would then be moved to a new legal entity. This is done because, often, the debt level is more a personal decision rather than a specific operational one. More importantly, a new entity leaves behind whatever business that was conducted with the old entity (and this is a potential legal risk). As a result, the new owner does not “inherit” the potential wrongdoings of the previous owner.
This is a different definition to “valuing the enterprise or firm”, which includes all that makes up an asset value, plus a normal amount of net working capital (NWC). NWC is the difference between current assets and current liabilities. This working capital is used to fund the business’ operations day to day, such as cash, accounts receivable and payable, inventory, etc.
When it comes to valuing the “ownership” of a business, this refers to the specific position of the equity holders (e.g., when you own ten shares in a public company you are an equity holder or, put another way, the owner of that company). For many valuation purposes, we want to find the value to the equity holder, the “equity value” (the article Valuing Equity goes into more detail about its calculation). In simple terms, it’s saying how much value the owner has remaining after debts are paid (bank loans, etc.). This is the number that the IRS is interested in for working out what taxes need to be paid, or when, in litigation contexts, one business owner has to buy out the other and they need to pay for the value of the equity position.
Another determination of value, which often sits within the equity value determination, is the value of goodwill. When it comes to valuing goodwill, you first need to understand what goodwill is.
In a business context, goodwill is the value of everything in the business that generates value and can’t be separated and individually valued. It’s a little tricky to understand initially but what it means is this: 1) your company has identifiable tangible assets such as machines (fixed assets that you can touch and see), inventories (short-term assets that you can also touch and see), vehicles, and furniture, among other tangible assets and 2) your company also has some identifiable intangible assets such as customer relationships and brand. All those assets together generate a certain amount of cash flows/profits that drive the company’s value. Each of these assets above can be separately identified and valued, but after valuing all of them, the company’s value that was determined could be higher than the sum of the assets together. This difference is known as goodwill (additional value that cannot be identified and separated that is generated beyond the sum of the parts).
Step #11: What Is a Standard of Value?
Now that you know what you’re valuing, the framework then continues to the various “standards of value”, considering them all but with only one being selected. The Standard of Value, meaning the type of value being applied in the engagement, is best explained with examples of the various standards themselves.
The most common standard is the business Fair Market Value which, defined simply, is the hypothetical transaction between two hypothetical market participants, both knowledgeable and willing to transact, effectively taking a hypothetical cross section of potential buyers or sellers in the market. This is different to what the value would be to two specific parties (i.e., not a market-wide blanket of potential participants). For example, an entrepreneur has developed a new software that is better than the existing competition and is quickly gaining traction and market share. The existing larger competition may choose to value the new software company more than a normal market participant that does not have such a specific interest in their product and maintaining their market share.
The Fair Market Value standard is used for a range of purposes in today’s environment. An important one in particular is the tax system in which parties need to identify a value that is fair, considering the market where the company operates to determine what taxes need to be paid (if any).
Other standards that exist are the Fair Value standard, often used for litigation purposes between specific parties (i.e., removing the “market” element). There is the Investment Value standard, in which the investor will only buy to get a “good deal”—often the value is below fair market value. The Synergistic Value standard is when a specific party can extract additional value relative to a normal market participant due to the synergies, like a retailer buying their wholesaler. The final standard of value is called Intrinsic Value, which is particular to financial analysts that value the business/asset different to what the market does (to derive a valuation the rest of the market does not see or agree with yet).
Step #12: How to Value a Business?
This part covers what comes to mind when most people think of valuing a business—the calculation or number crunching part. At this point, it’s clear you can’t arrive at the calculation part unless you have the context in place from the framework above. Also, it’s not just limited to number crunching; as you learned in Part 1, business valuation is the combination of both science and art, so in addition to number crunching there’s considering the qualitative data available, too.
The framework gives us three valuation approaches to consider and use, each with their own specific methods. Based on the decisions made in the previous framework questions, plus all the relevant quantitative data (financial statements, amongst others) and qualitative data (details such as the legal actions against the company or how most of the clients are attached to the owner, called Key Man risk, which helps build the risk profile of the business), the valuer will choose the most appropriate approach(es) and method(s) to use.
The first and often most preferred approach is the Income Approach, which uses the income or cash flows/profits the company is expected to generate in the future and finds the value of those cash flows as of today ($100,000 a year from now is not worth the same as $100,000 today). Within the Income Approach, there are two main valuation methods. The first one is the Capitalization of Income method, which identifies one single measure of annual sustainable cash flows, and uses that measure for each year into the future (more details on this are explained in our article How to Calculate the Value of a Business For Sale). This is a common method for businesses that have a relatively consistent history and don’t foresee any material changes. But what to do if you do foresee changes, like expanding to a second store, shutting down a business department, or a new software company that is experiencing strong growth? You need a method that is more flexible to capture the expected changes in cash flows/profits. The Discounted Economic Income (or Discounted Cash Flow if income is defined as cash flows) method is designed for this. It effectively splits the expected cash flows/profits into two parts: the expected change (opening of the second store or department shutting down) and then a consistent prediction after the changes are completed.
The second approach is the Market Approach, which uses, for example, previous transactions of other businesses (businesses that are similar enough to the business being valued) to compare the price/value relationship. For example, when valuing a retailer that sells and fits car tires in NYC, if you could see what other car tire retailers were sold for, it would give you a good indication of value in the market—especially if those retailers have similar characteristics (such as sales and profit levels), are servicing the same area, or have a similar number of employees (among other factors). However, the price in these transactions does not always equal value. For example, what if those transactions were under the Synergistic Value standard? That wouldn’t work for a Fair Market Value standard valuation. In private company transaction data, this information is almost never captured, so it would be difficult to determine if there is synergistic value being captured in the price.
The Asset-based Approach (not to be confused with the asset value mentioned previously) determines the value of the company based on the assets and liabilities on the balance sheet restated to reflect their current economic values. This is different from the Income Approach, which is based on the income generated from the assets themselves. A simple example of when to use this approach—again, depending on the initial framework questions—is if the company needed to be valued under the Liquidation Value standard, meaning the assets were not going to produce any more income as they would soon be liquidated (i.e., sold). Another example is when the assets themselves are greater than the value of the income they produce, such as real estate companies and capital-intensive businesses.
Step #13: Understanding the Basics of Financial Statements
In order to properly assess the valuation approaches and methods above, you need a good understanding of the three basic financial statements as a baseline. These are the income statement, the balance sheet, and the cash flow statement. Each statement serves a different purpose and they are interlinked to serve an overall objective, which is to holistically understand, review, and take action regarding the financial situation of the business. A deep dive into the workings of these financial statements is beyond the scope of this e-book; however, we have several articles available with more details. For example, to understand the income statement and earnings metrics, see income statement and EBITDA. To understand the balance sheet, there are articles on accounts receivable, accounts payable, non-current assets, and net working capital.
Step #14: How to Determine Risk and Reward
Earlier, we discussed the Income Approach and how to determine the value—it uses the expected cash flow/profits of the company. Those cash flows are not guaranteed to happen. There is a risk element there that what you estimated will not happen exactly as anticipated. This is normal, as all investments carry risk. For example, when you invest in the stock market, the profits of the public companies have several risks associated, and you could earn a return of approximately 6-10% over the long term for bearing those risks. Just like with public companies, private companies also have risks, which are generally larger than those of the public ones. This is where the valuation practitioners and their special skillsets come into play, assessing the many data points, both quantitative and qualitative, to obtain this risk assessment accurately. We often see private businesses within a range of a 10-20% expected return, meaning you demand a much higher return than a government bond, or a public company, because the private business is a higher-risk investment.
Step #15: Cost of Capital
Capital simply means the way you fund your operations. Where do you get money from to inject into your business? Is it from reinvestment of profits or is it from selling a percentage of your business (both are forms of equity funding)? Alternatively, did you acquire a loan from a bank or another financial institution (debt funding)? Both forms of funding, equity and debt, have a cost, which are related to the risk assessment of the business. Many companies typically have both forms of funding, and when you accumulate a good working knowledge of this topic, there is an optimal or strategic way to fund your business using the right debt to equity proportion, keeping the costs and risks low. More on this can be found in our article Cost of Equity & Cost of Debt.
The aggregate of the “costs” to the type of capital sources (equity or debt) represents your opportunity cost. In other words, it is the return you forego by choosing to invest in the business instead of something else, such as buying government bonds or shares in public companies. At this stage, it is clear that the risk/return of the public company is different from that of your business. Therefore, if your business is deemed riskier than public companies (as smaller businesses generally are), the cost of equity would be higher than that of the public companies.
The cost of debt is much simpler compared to the cost of equity—one bank will lend you money at 5% and another at 6%. The rate at which the bank lends you money (minus the tax shield, as interest paid is tax deductible) is the cost of that debt. In small businesses, debt is often looked at as very risky, but if the business generates steady positive cash flows, it is actually the cheaper form of funding. Another interesting component affecting the cost of capital is the impact of inflation (refer to our article How Does Inflation Impact Your Business?, which walks you through the impact to your company’s value).
Once you have identified what you’re valuing (the assets, enterprise, or equity of the company) and applied the appropriate approaches and methods, what you arrive at is 100% of the value. For example, under the Fair Market Value standard, using the Income Approach and the Discounted Economic Income method, the equity of the company was valued, meaning 100% of the equity. But what happens if you own 40% of the company and your business partner owns 60%? How do you arrive at 40%? Do you take the derived value and multiply it by 40%? The answer depends on what framework decisions were made earlier.
In this example, we valued the company under the Fair Market Value standard, which means taking a hypothetical buyer/seller in the market. Therefore, to answer the question you need to ask what rights and privileges does the 40% come with. Does it come with complete control to make decisions? Under a typical structure, the 60% owner would have the power or control, not the 40% owner, who is a minority owner. Also, if you wanted to sell that 40% share to a hypothetical market buyer, do you think that it would be equally as attractive (marketable) or as easy or fast to sell as a 100% share? Well, the 40% doesn’t have control, since they have the existing 60% owner to deal with, and private businesses—unlike a share from the public stock market—cannot be sold easily to receive the money in your bank within three days. Therefore, what we have is a control issue and a marketability issue with the 40% minority stake. This is where a discount is applied to such minority stakes, both a discount for lack of control and a discount for lack of marketability.
This topic can have a big impact on the value of the share interest being valued, in which common discounts (depending on many factors) can be between 10-50%. It is also the part of valuation that is greyer, meaning that it is difficult to quantify an exact percentage that can’t be questioned or argued against.
As an example, you may think you have a $1 million company (which means my 40% is $400,000), but in reality, a market buyer will point out that there is no control with that and it is also much harder to sell than a controlling stake. Therefore, they will give you just $250,000 for it, which is a fair price after considering discounts.
There is a framework that all accredited valuation practitioners must follow, and each piece of information has its purpose that will impact the derived value. This e-book has given you a high-level overview of the process and an introduction to the main approaches and methods. In reality, proper valuation of a company—in which the result is defensible for another practitioner, the tax department, litigation lawyer, or an astute buyer—requires a high level of skill and knowledge. Your job as the business owner is far simpler:
- Select the right valuation practitioner (see Part 1 for tips on how to do this)
- Provide the practitioner with accurate and timely information
As with most things, the quality of the output is derived from the quality of the input. If the information to the valuation practitioner is incorrect (due to inaccurate financial statements or biased information from the owner), this can make the output less accurate.
Can I Use Automation Software?
As technology advances, we continue to find more ways to use it in new things or make existing technology better. How does this apply to the business valuation space? Technology is making the valuation process easier for practitioners, since it allows us to collect massive amounts of data and turn it into information, providing the practitioners with more reliable information with which to enhance the accuracy of their valuations. However, where does this stop? Where is technology now and what are the limitations? Most importantly, can it be relied on? See the Business Calculator article that dives into this topic.
What Are Intangible Assets?
The easiest way to think about this is to start with this question: what are tangible assets? You know these as the physical assets you can “touch”, such as machinery, work vehicles, cash in the bank, etc. Intangible assets are the opposite—those that are not physical in nature but still exist, such as intellectual property (IP) that could be special code in software, copyright as the protection of a song or piece of artwork, branding, or know-how, among many others. These, as you can imagine, can be more difficult to value, but specialized valuation practitioners have specific methods to value intangible assets.
Same Business, Two Different Values
Valuation, as explained in Part 1, is an “opinion of value”, and opinions are often different. If there are no external motivations or biases, the better the practitioner is, the closer the estimated range of value will be compared to those from other quality practitioners. But what happens in the real world? Everyone has their own motivations, and this creates biases. Therefore, depending on the purpose, appraisers may push and pull their “opinion of value” to what is desired. As an example, do you think that the valuer for the IRS when valuing the Michael Jackson estate court case (the motivation there is to increase tax revenue) found a valuation $157 million higher than that of the valuation practitioner of Michael Jackson’s estate? And vice versa? The practitioner for Michael Jackson’s estate to come in $157 million lower than the valuation from the IRS is no surprise (this demonstrates motivation to pay less tax).
Hopefully, this e-book has made you a fair bit more knowledgeable when it comes to business valuations and what will make a successful engagement. Happy valuing!